Investors will favour real asset classes offering growth potential in an environment of increasing bond yields, argues real asset analyst Vivienne Bolla.
5 minute read
As central banks gradually withdraw the extraordinary monetary support of recent years, pretty much all financial asset classes are having to adjust to the likelihood that the secular bull market in bonds is over. Except for gold and some other commodities, ‘real assets’ are no different.
However, investors need not be alarmed. For a start, while inflation seems likely to pick-up, there is every reason to believe inflation expectations will remain anchored as they have done since the adoption of inflation targeting in the 1990s. That means central banks are likely to have to tighten policy less than in the past to meet their inflation objectives.
Yields to rise, but to a significantly lower level than normal
At the same time, the various forces that have driven real yields lower in recent decades are not going to disappear in a hurry. Together, these factors mean any further rise in nominal bond yields should be modest. For example, the German ten-year Bund yield is expected to rise to just one per cent by the end of 2021, compared to an average of 4.3 per cent between 2000-2007.1
Given this backdrop, there seem strong grounds to believe institutional demand for real assets will continue to grow. For a start, with the current phase of economic expansion in the developed world now arguably into its latter stages, the steady and predictable income streams offered by many types of real asset will continue to appeal. The fact they offer varying degrees of protection against inflation adds to their allure.
Furthermore, since bonds yields are expected to stay low by historical standards, the illiquidity premia offered by real assets will remain attractive to investors as they attempt to secure a pick-up in prospective return. At the same time, should asset price correlations stay comparatively high as markets continue to be led by the actions of central banks, real assets are likely to continue to offer one of the few ways for institutions to secure meaningful portfolio diversification.
A supportive regulatory environment
Regulatory changes also help to explain the recent growth in institutional demand for real assets, particularly on the debt side. For example, banks, which until recently had been the biggest providers of capital, have been scaling back lending in this area due to higher capital charges under Basel III regulations. This has created space for institutions fill the void. Meanwhile, amendments to Solvency II regulations have made many of these types of investments more attractive to European insurance companies.
However, it is important to recognize that since real assets are a diverse, complex and illiquid asset class, investors need to devote significant resources if each individual opportunity is to be fully researched on its merits. Below we consider the main categories of real assets and the different ways in which they are likely to respond if, as we expect, interest rates rise further but peak at a much lower level than in past economic cycles.
Real Estate Equity: choose assets with growth prospects and reduce leverage
Equity investments in real estate encompass three main types of strategy: core, value-add and opportunistic.
As core real estate is valued for the stable income it produces, its price tends to be closely correlated to movements in government bond yields, albeit with a lagged effect. As would be expected, rising interest rates are historically associated with weaker real estate performance, especially from assets that are highly levered. In return for assuming various risks, including reduced liquidity, investors can expect to receive a pick-up in yield.
The fortunes of value-add and opportunistic strategies are less closely correlated to government bonds since both offer growth in addition to, or in some cases instead of, income. As interest rates tend to rise when the economy is strengthening, these types of strategies will tend to outperform core real estate when government bond yields are climbing, as long as investors are not excessively levered.
In summary, as bond yields rise, investors should favour value-add and opportunistic strategies over corereal estate since they offer income growth potential. They should also look to reduce leverage.
Real Estate Debt: focus on longer-dated loans
Should higher rates lead to a fall in property prices, that could impact the value of debt written against that property. However, with much of the sector quite conservatively geared, some fall in values can be tolerated.
Higher rates will also make it harder for some mortgagors to continue servicing their debt. To reduce this risk, investors can focus on longer-dated loans to borrowers in healthier financial positions and with strong long-term strategies.
Notwithstanding these risks, institutional demand for real-estate debt is likely to remain firm given the stable income streams offered. For now, we believe the prospective returns on real estate debt looks more attractive than those from real estate equity.
Long-Lease Real Estate: favour leases linked to inflation or offering fixed uplifts
Long-lease real estate is something of a hybrid, retaining both equity and bond-like characteristics. It is arguably the most defensive way to invest in property. The focus is on assets with long leases and reliable tenants, such as public-sector bodies or highly-rated companies. To maintain the real value of distributions, leases that are linked to inflation or which offer fixed uplifts are favoured.
These assets can be especially attractive to pension funds and other institutional investors looking for stable income streams to match long-term liabilities. Long-lease real estate can provide a good proxy for the income streams provided by both conventional and inflation-linked government bonds, but with a meaningful pick-up in yield.
Long-lease real estate is generally priced against government bonds and does not typically offer any ‘real’ growth in capital. Asset values are therefore sensitive to interest rates, although by the same token there is limited exposure to the wider property market.
The ability of this type of asset to match long-term liabilities and hedge against inflation means that, so long as any rise in interest rates is modest, demand should hold up, particularly given the ongoing desire of defined-benefit pension schemes to plug funding shortfalls.
Infrastructure (Equity and Debt)
Countries around the world are under pressure to boost infrastructure spending. Developed nations need to upgrade infrastructure following years of underinvestment, as they look to cut carbon emissions and roll out new technologies such as fibre broadband. As for emerging nations, they need new infrastructure to support rapid population growth, especially in urban areas.
However, many governments are reluctant to spend the money necessary as they battle to get sky-high deficits under control and this seems unlikely to change in the foreseeable future. 2 With banks simultaneously looking to scale back lending activity, a funding gap is being created that institutional investors are willing to fill. After all, they are being offered a wide variety of attractive infrastructure investment opportunities. Preqin estimates that unlisted infrastructure assets under management globally hit a record US$418 billion in June 2017 and that 69 unlisted infrastructure funds closed during 2017 securing an aggregate US$65 billion. 3
Infrastructure is a complex asset class with investment opportunities available at different levels of the capital structure. The impact of rising rates will depend on where in that structure investors have exposure.
Infrastructure Equity: favour assets with income growth potential
Higher rates depress infrastructure equity valuations, since applying a higher discount rate depresses the ‘net present value’ of the future streams of income the asset is expected to generate. However, as an illiquid and long-term investment, this may not be of great significance for many owners. To the extent the asset offers capital income growth or protects against inflation, investors are partially shielded from the impact of higher rates anyway.
Infrastructure Debt: a useful diversifier to bond portfolios
While rising rates will negatively impact infrastructure debt prices, it is a diverse and versatile asset class that can appeal to investors on various grounds. A key attraction is that returns tend to be safer and more predictable than those offered by corporate bonds. This is for three main reasons.
Firstly, unlike most bonds, infrastructure debt is often collateralized against a specific group of assets or stream of cash flows. As a result, recovery rates in the case of default tend to be much higher than for corporate bonds.
Secondly, infrastructure investment is usually undertaken by businesses operating in one of four sectors: utilities, energy, transport and healthcare. Since these businesses often provide essential services, their revenue streams tend to be less sensitive to the economic cycle. Investing in them provides a means of diversification away from what is traditionally one of the main drivers of corporate bond returns.
Thirdly, as the owners of many infrastructure assets are quasi monopolies, they are often subject to regulation. One consequence of this is that operators are often granted long-run contracts, with revenues in many cases linked to inflation. This can be especially advantageous to those pension funds and life insurers looking to match long-term liabilities.
A multi-asset approach to mitigate risk?
If interest rates remain low by historical standards, as we expect, investors are likely to increase their exposure to real assets given their ability both to enhance returns, via their illiquidity premium, and to diversify traditional portfolios. The fact many investors remain underexposed to them makes this all the truer.
Since the real assets universe is diverse, a multi-sector approach can help mitigate risk by bringing benefits to portfolios at different stages of the interest-rate cycle. However, since they are also a complex and illiquid asset class, long-term outperformance is achieved through the disciplined deployment of capital.
1 Source: Macrobond
2 “Bridging Infrastructure Gaps, Has the World Made Progress?” McKinsey Global Institute, Oct 2017
3 Preqin 2018 Global Infrastructure Report